n January 2007, Metro do Porto, a light rail network, entered into an interest rate swap agreement with Banco Santander Totta on a notional principal of €89 million. The intent was to reduce the interest costs that Metro do Porto was incurring. This was a complex swap agreement that brought immediate benefits to Metro do Porto but proved catastrophic in the long run. Two years after the swap commenced, a “snowball clause” in the swap agreement took effect, increasing Metro do Porto’s liability beyond 60 per cent per annum at a time when market interest rates were low and expected to drop even lower. It was unclear whether the company entered into this agreement out of ignorance, political pressure, or both, but the end result was a lawsuit. Students are expected to analyze the terms of this swap and decide whether the swap constituted good practice from a risk management perspective and whether Metro do Porto should have been able to anticipate the possible losses.
Case questions to guide your analysis:
1. Analyze the swap structure and comment on whether MdP entered into a speculative transaction or one designed to reduce risk
2. Compute MdP’s net cash flow on the payment dates
3. What might motivate company executives and bankers to enter into such contracts?
4. Prepare a Monte Carlo Simulation of the swap structure to evaluate the “reasonableness” of entering into this swap.
5. Suggest methods to reduce the risk of derivatives mishaps in companies.
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